Microsoft Corp and Yahoo Inc inked a 10-year Web search deal to better compete against market leader Google Inc but stopped short of combining their display advertising businesses.
Yahoo shares fell 7.5 percent, as some investors were disappointed by the limited scope of the deal. Shares of Microsoft edged higher, while Google shares fell 1 percent.
"Those that were looking forward to a take-out, the deal today was rather disappointing," said Marc Pado, U.S. market strategist for Cantor Fitzgerald & Co. "The 10-year pact, it's not a bad thing. It's not as good as what investors expected."
Under the deal announced on Wednesday, Microsoft's Bing search engine will be the exclusive algorithmic search and paid search technology for Yahoo's sites, while Yahoo will be responsible for selling premium search ads for both companies.
Yahoo estimated the deal will boost its annual operating income by about $500 million (£304 million) and yield capital expenditure savings of $200 million (£121 million). Yahoo also expects the deal to boost annual operating cash flow by about $275 million (£167 million).
Yahoo reported income from operations of $13 million (£7.9 million) in 2008, hurt by $487.5 million (£297 million) in goodwill impairment charge and $107 million (£107 million) in restructuring charges. In 2007, operating income was $695 million (£423 million).
Ross Sandler, analyst at RBC Capital Markets, said some people will be disappointed that Microsoft did not give Yahoo a big upfront payment, but noted that the partnership was good overall for the two companies.
"Overall, it's a big positive for two companies that have been struggling to keep up with Google. This consolidates their resources and allows them to make a more concerted push as the No. 2 entity," he said.
Microsoft Chief Executive Officer Steve Ballmer said the deal gives its new search engine, Bing, the scale needed to attract more users and advertisers.
Yahoo, meanwhile, said it will focus on its portfolio of websites, expanding into mobile advertising and other products.
Under the deal, Microsoft will acquire an exclusive 10-year license to Yahoo's core search technologies, and it will combine them with its own search technologies.
Microsoft will compensate Yahoo through a revenue-sharing agreement and pay traffic acquisition costs (TAC) to Yahoo at an initial rate of 88 per cent of search revenue generated on Yahoo sites in the first five years.
Each company will maintain its own separate display advertising business and sales force, they said.
The deal combines the number two and number three players in the U.S. market for Internet search and positions them to better compete with Google, which has an estimated 65 percent share of the U.S. search market.
The companies said they expect the deal to be "closely reviewed" by regulators, but were "hopeful" it can close in early 2010.
Shares of Yahoo were down $1.34 at $15.88 in early Nasdaq trading. Shares of Microsoft were up 36 cents to $23.83. Google shares fell $4.55 to $435.30.